Bonds are safer than stocks because you get your investment back at maturity, plus interest semi-annually.Getty Images/iStockphoto
Have the people pouring money into bonds given any thought to what inflation will do to their investment?
The question has to be asked with the five-year Government of Canada bond yield at 0.7 per cent and inflation running at 1.3 per cent as of last month. According to the Bank of Canada's investment calculator, the effect of inflation on an investment today of $10,000 in a five-year Canada bond held to maturity would give it a total future value of $9,707.33.
Bonds are safer than stocks because you get your investment back at maturity, plus interest semi-annually. But demand for this safety is so intense that bond yields have fallen to shockingly low levels (bond prices and yields move in opposite directions). Investors are well aware of this harshest of today's investing realities. What they may not recognize is the extent to which money put into bonds today will lose money on an after-inflation basis.
Canada bonds offer the most extreme example of this problem because they're the safest of bonds and thus offer the lowest yields. But provincial bonds are only marginally better. A five-year Ontario bond offers a yield of around 1.2 per cent. If we use the same 1.3-per-cent inflation rate, an investment of $10,000 would over five years provide a total future value of $9,950.73 after inflation.
You can beat inflation with blue-chip corporate bonds, but not dramatically. A five-year Sun Life Financial bond has a yield around 1.7 per cent. After inflation over five years, $10,000 turns into just $10,199.
We're actually going easy on bonds here by using July's inflation rate of 1.3 per cent. If we used a 2-per-cent inflation rate, a reasonable default for longer-term expectations, then even that corporate bond is an after-inflation money loser. A $10,000 investment produces a future value of $9,853.81 in that example.
Stocks provide inflation protection in a portfolio, so don't give up on bonds because of their weak return potential on an after-inflation basis. But you can be a more discerning buyer of bonds. High-grade corporates offer more yield than government bonds, and GICs can offer better yields than any type of investment-grade bond. More about this in an upcoming column.
Rob Carrick